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Muni Bonds' Tax Exemption Likely to Stay

Congressional lawmakers are skeptical of some specialty tax-free bonds but largely spoke in support of maintaining the tax-exempt status of the municipal bonds localities and states issue to fund infrastructure projects.

Congressional lawmakers on Tuesday voiced skepticism about some specialty tax-free bonds but largely spoke in support of maintaining the tax-exempt status of the municipal bonds that localities and states issue to fund infrastructure projects.

During a hearing on tax reform held by the U.S. House Committee on Ways and Means, several committee members asked a panel of tax and local government experts what would be an appropriate use of private activity bonds. The bonds, issued on behalf of private developers, make up a small percentage of the overall bond market and are often used in special cases like post-disaster reconstruction and, as recently pointed out by the New York Times, in private projects. Panelists’ answers ranged from nixing them entirely (the recommendation of the Tax Foundation) to limiting their use.

“I would caution against eliminating them entirely,” said John Buckley, a professor for Georgetown University Law school’s graduate tax program. While Buckley believes the bonds’ use in disaster recovery should be kept, "this is an area I think the committee should look at," he said.

Rep. Danny Davis of Illinois, however, cautioned the committee to not nix all tax-exempt bonds just because they don’t like some of them.

“There are some components of this that may not be as good but that does not mean the concept is not worthy,” he said. “Many of us are firmly convinced that many local infrastructure projects simply would not get done if the bonds were not available."

On the same day of the hearing, the American Society of Civil Engineers released its four-year infrastructure report card, giving U.S. infrastructure a D+ grade and estimating that the country faces a $1.6 trillion funding shortfall for needed infrastructure improvements. With that in mind, committee members repeatedly expressed their support for keeping municipal bonds' tax-free status intact.

Localities and states have been lobbying hard to keep the interest on the bonds tax-free, arguing that taxing the interest would make it more expensive for governments to borrow money because they would have to offer a higher yield to investors than they do now. This, supporters say, would have the effect of slowing down infrastructure development and would cut into job creation. Those who support taxing the interest say the current structure amounts to a tax break for the wealthy people who invest in the bonds.

Scott Hodge, president of the Tax Foundation, testified that the tax exemption actually encourages “unwanted behavior” from state and local governments by enabling them to invest more in infrastructure than they otherwise would.

If the bonds were taxed, he said, "It might encourage a city to reduce its overall amount of borrowing and be more prudent in deciding what it will build."

But Rep. Bill Pascrell was one of several representatives who took issue with that sentiment. Rep. Pascrell’s home district in northern New Jersey was one of the areas devastated by Hurricane Sandy last fall.

“Municipalities don’t have the money, states don’t have the money, so we might as well wait until they have money [to rebuild]?” Pascrell asked Hodges. “That’s just not acceptable.”

The bonds' tax-free status was on the chopping block during Congress' fiscal cliff talks at the end of last year, but they ultimately were left untouched in the final deal that was reached in early January. Taxing muni bonds would add billions of dollars of new revenue to the national government -- as much as $40 billion annually, according to some estimates. But Committee Chairman Rep. Dave Camp has said his comprehensive tax reform plan won't be used to generate more tax revenue -- he's more interested in simply streamlining the nation’s tax code.